Who Works for Whom?
Worker Sorting in a Model of Entrepreneurship
with Heterogeneous Labor Markets∗
Emin M. Dinlersoz† Henry R. Hyatt‡ Hubert P. Janicki§
November 2015
Abstract
Young and small firms disproportionately hire from the pool of younger, less wealthy,
and nonemployed individuals, and provide them with lower earnings than other firms do. To
explore the mechanisms behind this sorting of workers, a dynamic model of entrepreneurship
is introduced, where individuals can choose not to work, become entrepreneurs, or work
in one of the two sectors: a corporate versus an entrepreneurial sector. The differences in
production technology, financial frictions, and labor market frictions lead to sector-specific
wages and worker sorting across the two sectors. Individuals with lower assets tend to
accept jobs with lower pay in the entrepreneurial sector, an implication that finds support
in the data. The response of the entrepreneurial activity to changes in the key parameters
of the model is also studied to explore the channels that may have contributed to the decline
of entrepreneurship in the United States.
Keywords: Entrepreneurship, borrowing constraints, worker sorting, labor market frictions, decline in entrepreneurship
JEL Codes: L26, J21, J22, J23, J24, J30, E21, E23, E24
∗
Any opinions and conclusions expressed herein are those of the authors and do not necessarily represent the
views of the U.S. Census Bureau. All results have been reviewed to ensure that no confidential data are disclosed.
†
Corresponding author. Center for Economic Studies, U.S. Census Bureau, 4600 Silver Hill Road, Suitland,
MD 20746. Tel: (301) 763 7889, Fax: (301) 763 5935, E-mail: emin.m.dinlersoz@census.gov
‡
Center for Economic Studies, U.S. Census Bureau, and IZA E-mail: henry.r.hyatt@census.gov
§
Center for Economic Studies, U.S. Census Bureau E-mail: hubert.p.janicki@census.gov
1
Introduction
Job creation by entrepreneurs is an important component of employment dynamics in the
U.S. labor market. In a typical year, new firm startups account about 3% of total employment
but almost 20% of gross job creation.1 The jobs entrepreneurs create, however, may not always
be the most desirable ones. A variety of new data sources for the United States have confirmed
that entrepreneurial firms, most of which are young and small, provide lower earnings to their
workers on average compared with older and larger firms, and tend to hire more from the pool of
workers who are nonemployed.2 Using young firms that are at most five years of age and small
firms with at most 20 employees as approximations to the population of entrepreneurial firms,
Table 1 highlights these differences across entrepreneurial versus other firms. The differences are
highly persistent over time. The new data sources also reveal that entrepreneurial activity in the
United States has been declining persistently. Some of the trends are summarized in Table 1 and
Figure 4. The fraction of businesses that are young fell between 1982 and 2012. At the same
time, the share of employment in both young and small firms has been shrinking. The average
real earnings of workers in young firms have also declined over time relative to other firms.3
Despite the attention given to young and small firms’ contribution to job creation and destruction, and to firm turnover in the United States, the mechanisms by which workers sort
across entrepreneurial versus other firms remain relatively less understood. What kind of workers choose to work for entrepreneurial firms, and why? In particular, how do the productivity
and wealth of workers differ across entrepreneurial versus other firms? How do the performance
of the entrepreneurial firms and the nature of the match of workers with these firms depend on
financial and labor market frictions? These questions demand a framework where individuals
face not only the choice between being entrepreneurs or workers, but also the choice between
working for entrepreneurial versus other firms. These choices are influenced by several frictions
in markets. Financial frictions for entrepreneurs and workers, and search frictions in the labor
market, affect the flow of individuals between entrepreneurship and working for someone else. A
better understanding of the functioning of the labor markets for entrepreneurial firms under these
frictions is important for an analysis of how the two group of firms have fared in recent decades.
The decline in entrepreneurial activity has consequences for the labor market for entrepreneurial
1
At the same time, about 40% of the jobs created by startups also disappear due to exit within 5 years of
entry. See Haltiwanger, Jarmin, and Miranda (2013).
2
See, e.g., Brown and Medoff (1989) for the connection between firm size and earnings. Brown and Medoff
(2003), Kölling, Schabel and Wagner (2002), and Dinlersoz, Hyatt, and Nguyen (2013) document, among others,
the connection between age of establishment or a firm, on the one hand, and average earnings of workers, on the
other.
3
See Davis and Haltiwanger (2014) and Decker, Haltiwanger, Jarmin, and Miranda (2014a,b) for a documentation of some of these facts.
2
firms, and conversely, the changes in the labor market for such firms have implications for the
performance of the entrepreneurial firms.
This paper develops a dynamic model of entrepreneurship to analyze what kind of individuals work for entrepreneurial firms, and who becomes an entrepreneur. In the model, individuals
differ in wealth, as well as ability (or productivity)—both as a worker and an entrepreneur. The
worker and entrepreneurial ability both fluctuate over time. Each individual can choose among
not working, being an entrepreneur, or working as an employee in one of the two sectors, entrepreneurial and corporate—a label that represents the set of firms that don’t face the constraints
entrepreneurial firms do. These constraints are of two types. First, the entrepreneurial production is subject to diminishing returns that arise from the limits to entrepreneurs’ span-of-control.
In contrast, firms in the corporate sector can scale up production without such restrictions. In
addition, entrepreneurs face financial constraints. They can borrow only up to a limit to operate
their businesses, a constraint that does not apply to corporate sector firms.
The match between workers and firms is subject to frictions in the labor market. Not all
nonemployed individuals can find a job, and workers can be separated from their employers
involuntarily, in addition to voluntary separations. The labor market frictions vary across the
entrepreneurial and corporate sectors. Job offers come at different rates from the two sectors.
Involuntary separations also occur at different rates. At any point in time, an individual can
get a job offer only from one of the two sectors. However, workers can flow in and out of the
sectors over time, subject to the frictions described. The differences across the two sectors in
production technology and labor market frictions together lead to different sectoral wages per
unit of worker efficiency. Given this wage differential, the heterogeneity in worker productivity
and wealth implies that workers sort across the two sectors.
The model outlined above is related to a class of recent models on entrepreneurship.4 These
models generate plausible fractions of entrepreneurs in the population, as well as the distributions
of wealth for entrepreneurs and workers. What distinguishes the framework considered here from
these models, however, is the presence of sector-specific labor market frictions. This feature
generates employment share and earnings differentials in the two sectors that are consistent with
what is observed in the data for entrepreneurial versus other firms. It allows for an analysis of
how the two sectors differ in the type of workers they attract, the share of employment they
account for, and their average worker earnings. The model also provides an environment for
exploring how changes in the financial and labor market frictions influence the performance of
the entrepreneurial sector.
The calibrated model’s equilibrium offers a number of insights to the functioning of the
4
See, among others, Quadrini (2000), Cagetti and De Nardi (2004), Kitao (2008), Buera and Shin (2011),
Buera, Fattal-Jaef, and Shin (2015), and Bassetto, Cagetti, and De Nardi (2015).
3
entrepreneurial sector. First, the model generates a lower wage per unit of worker efficiency,
as well as lower average worker earnings, in the entrepreneurial sector relative to the corporate
sector. This difference is consistent with the observed firm age-worker earnings premium. In the
model, higher average earnings in the corporate sector emerge due to a combination of factors.
One factor is that job offers arrive at different rates from the two sectors. As a result, the wages
per unit of worker efficiency are not necessarily equalized across the two sectors. Other factors
are the decreasing returns to scale and borrowing constraints in the entrepreneurial sector. These
features of the model together imply that entrepreneurs on average operate at lower scale and
generate lower profit than the corporate sector, and hence, can not offer wages as high as those
in the corporate sector.
Second, the model provides an answer to the fundamental question of who works for whom.
Workers in the entrepreneurial sector tend to be less wealthy and more productive individuals.
This result is in part driven by the fact that workers who are employed in the corporate sector
accumulate more wealth over time than their counterparts in the entrepreneurial sector, as a
result of the higher wage rate in the corporate sector. A stronger result, however, is that individuals who take jobs in the entrepreneurial sector when nonemployed also tend to be less wealthy
and more productive. That is, the wealth and productivity differences across the two sectors
apply even to individuals who are in their first period of employment following a transition from
nonemployment. If a nonemployed individual receives an offer from the entrepreneurial sector,
the worker has to decide whether to reject this offer and wait for an offer from the higher-wage
corporate sector.5 Individuals with lower levels of savings and higher productivity tend to accept
job offers from the entrepreneurial sector rather than waiting. This sorting of individuals occurs
in the absence of any inherent preference for working for entrepreneurial firms, or any other form
of compensation such firms can provide their workers.
Third, the model provides several empirical predictions that have not been tested in detail in
previous work. One key prediction highlighted above, that workers with lower assets tend to work
for entrepreneurial firms and take jobs in the entrepreneurial sector, is broadly consistent with
the empirical facts about life-cycle asset accumulation, but has yet to be explored in data. This
prediction is tested using data on workers’ net worth merged with the data that captures employer
characteristics. The findings broadly support the baseline model’s prediction. In the baseline
model workers in the corporate sector have average asset holdings which are about 19 times the
average asset holdings of workers in entrepreneurial firms. This ratio is about 15 for workers
in their first quarter of employment. The corresponding ratios in the data are approximately
5
A similar mechanism is also at work in theoretical study of asset accumulation and employment studied by
Browning, Crossley, and Smith (2007), who do not aim to replicate the salient features of the U.S. entrepreneurial
sector.
4
15 and 16, respectively. The fact that lower average worker earnings in entrepreneurial firms
induce mainly workers with lower levels of assets to accept jobs from them, has implications on
the job offer rates from the two sectors. In order to match the empirical moments of interest,
the model requires an offer arrival rate from the entrepreneurial sector that is about one third of
that from the corporate sector.
Fourth, the model provides a framework to explore some of the channels that may have
contributed to the decline of entrepreneurship in the United States.6 Several performance metrics
for the entrepreneurial sector indicate a decades-long decline that has accelerated during the
Great Recession. The number of new employer businesses has been falling.7 The new businesses
that do form recently tend to create fewer jobs.8 The average worker earnings in young firms
have also fallen, relative to old businesses. In general, there is an “aging” of U.S. businesses, as
workers tend to be increasingly employed in older firms.9 The decline in the number of business
startups also explains part of the decline in employment reallocation rates.10 It is important to
understand the sources of the decline. The model allows for a qualitative exploration of some
of the channels that may be behind these trends through a series of experiments, where key
parameters of the model are altered one at a time to compare the resulting equilibrium with the
baseline. These experiments focus on the parameters that govern labor market frictions, financial
constraints, and entrepreneurial ability.
The rest of the paper is organized as follows. The next section documents some stylized
facts about entrepreneurial firms. Section 3 introduces the model, followed by its calibration in
Section 4. The properties of the baseline model are discussed in Section 5. Section 6 offers some
empirical evidence on the predictions of the model on worker sorting. Section 7 contains some
experiments to explore how entrepreneurship and worker sorting across the two sectors change
as some key parameters of the model are altered. Section 8 concludes.
2
Some Observations about Entrepreneurial Firms
This section presents some key features of entrepreneurial firms to motivate the model
and its analysis. A fundamental question is what exactly constitutes an entrepreneurial firm.
Table 2 provides several alternative definitions of the population of entrepreneurial firms and
6
Recent work on this decline include Pugsley and Sahin (2015) and Karahan, Pugsley and Sahin (2015). These
studies focus mainly on the decline in firm startups (a flow measure), which are a subset of entrepreneurial firms
(a stock measure) in the economy at any point in time, and abstract from labor and financial markets.
7
See Decker, Haltiwanger, Jarmin, and Miranda (2014a).
8
See Sedlacek and Sterk (2014).
9
See, e.g., Hathaway and Litan (2014a).
10
See, e.g., Hyatt and Spletzer (2013).
5
some accompanying statistics as of the year 2000. In the definitions in Table 2, non-employer
businesses are not included, as the main focus here is on job-creating entrepreneurs. In addition,
each firm is assumed to have a single owner—multiple owners, such as in the case of partnerships,
are not included.11 Entrepreneurial firms are often described as young and small firms, based
on employment—though what is "small" clearly depends on the nature of the business activity.
Although there are some young and small firms that are not entrepreneurial in nature (e.g. new
businesses that are a part of existing, established firms), and some entrepreneurial firms that
are young but large, firm age and size are frequently used to approximate the population of
entrepreneurial businesses. Assuming that the pool of potential entrepreneurs is the population
aged 25-64 years, the fraction of entrepreneurs in the economy can then be approximated as
the number of entrepreneurial firms divided by that population. Based on several age and size
criteria applied to the universe of employer-businesses in the U.S. Census Bureau’s Longitudinal
Business Database (LBD), Table 2 reveals that the fraction of entrepreneurs ranges from a
rather conservative estimate of 11% to a less stringent one of 37%. Alternatively, one can define
entrepreneurial firms as the set of firms that are non-public and have some type of ownership
demographics in the U.S. Census Bureau’s Survey of Business Owners (SBO). This approach
yields an estimate of 38% As another approach, one can use the responses of surveyed individuals
to the question regarding employer-business ownership in the Survey of Income and Program
Participation (SIPP). The estimates in this case vary from 23% to 29% Table 2 also indicates
that employment share of entrepreneurial firms varies between 36% to 440% across various
definitions. These definitions also imply a non-entrepreneurial firm average earnings premium
that is in the range 166% to 498%12
Consider now some of the fundamental differences between entrepreneurial and other firms.
For this purpose, define an entrepreneurial firm as one that is at most 5 years old.13 Table 1
highlights some key differences between entrepreneurial and other firms relevant for the analysis
here. First, entrepreneurial firms offer lower earnings to their workers on average. In 1987, the
median of the average worker earnings for entrepreneurial firms was about 85% of that for other
firms, whereas by 2012 this figure dropped to about 75% The average earnings premium for nonentrepreneurial firms is also highlighted in Table 2. The documented gap in average earnings
is consistent with a well-established empirical literature on firm-age and size premia in worker
11
The datasets used to construct Table 2 do not contain information about the exact number of owners for
each firm.
12
The average worker earnings premium is defined as excess average worker earnings in non-entrepreneurial
firms expressed as a percentage of the average worker earnings in entrepreneurial firms.
13
The findings summarized next are robust to some alternative definitions of an entrepreneurial firm in Table
2. For instance, using a 10-year threshold for an entrepreneurial firm does not make a substantial difference.
6
earnings.14
Table 1 also gives information on the prevalence and relative size of entrepreneurial firms.
Entrepreneurial firms accounted nearly as much as half of all firms in 1987, but this fraction
fell to around one-third in 2012. Compared to their representation in the population of firms,
entrepreneurial firms account for a relatively small share of total employment: nearly one-fifth in
1987, and only about one-tenth in 2012. The number and employment share of entrepreneurial
firms are in line with the typical high skewness in firm size and age distributions, which implies
that much of the economic activity is concentrated in a relatively small fraction of firms in
the right tail of these distributions. The average scale of entrepreneurial firms measured by
employment is also much smaller relative to non-entrepreneurial firms. The average employment
of the former is only about one-quarter of that for the latter. This difference arises because young
firms are generally smaller than older firms.
Entrepreneurial firms also exhibit marked differences in their worker hiring and separation
patterns compared to other firms. The former tend to have higher hiring and separation rates,
and rely more on those individuals without jobs for filling vacancies.15 Overall, as documented
in Table 1, in 2000 entrepreneurial firms accounted for about 24% of gross hires from nonemployment, and about 21% of gross separations to nonemployment. If entrepreneurial firms are defined
based on size rather than age, similar differences in hiring and separation patterns are observed
across the two groups of firms—see again Table 1. One can define the hires from nonemployment
for entrepreneurial firms relative to non-entrepreneurial firms as
³
´
Entrepreneurial firms’ share of total hires from nonemployment
Entrepreneurial firms’ share of total hires
³
´
Non-entrepreneurial firms’ share of total hires from nonemployment
Non-entrepreneurial firms’ share of total hires
The relative separations can be defined analogously. Both of these relative figures exceed one
for the two years considered in Table 1, indicating that entrepreneurial firms disproportionately
draw their workforce from nonemployment and lose their workers disproportionately to nonemployment, compared to non-entrepreneurial firms.
The differences across entrepreneurial and non-entrepreneurial firms suggest differences in
labor markets for these types of firms. In particular, the divergence in worker earnings, and
14
Brown and Medoff (2003) find that average worker earnings are lower in younger firms in a sample of U.S.
firms. This finding has repeatedly emerged in studies using a variety of datasets. For instance, Kölling, Schabel
and Wagner (2002) largely confirm Brown and Medoff’s (2003) findings using data that links establishments to
workers in Germany. Heyman (2007) also finds a similar pattern in Swedish data. More recently, Dinlersoz,
Hyatt, and Nguyen (2013) provide evidence that new manufacturing establishments in the U.S. provide lower
average earnings to their workers than older ones. Ouimet and Zarutskie (2014) also observe a similar gap in
average earnings in the matched employer-employee data for the U.S.
15
See Haltiwanger, Hyatt, and McEntarfer (2014) and Hyatt, McEntarfer, McKinney, Tibbets, and Walton
(2014).
7
hiring and separation patterns, hint at potentially different labor market frictions for these two
types of firms and their workers. Moreover, the discrepancy in their total employment and
average scale may stem in part from the more stringent financial and managerial constraints
entrepreneurs face. The model in the next section studies how all of these differences influence
the allocation of workers, and result in a gap in worker productivity, earnings, and wealth across
the two types of firms.
3
The Model
Considering the stark differences between entrepreneurial and non-entrepreneurial firms
highlighted in the previous section, the model features an economy with two sectors, entrepreneurial and corporate—a label that refers to non-entrepreneurial firms in the model.16 The
two sectors differ both in production technologies and labor market frictions. In addition, the
model recognizes individuals’ heterogeneity in wealth and ability, both as workers and entrepreneurs. It extends the framework of incomplete markets with occupational choice in the spirit
of Quadrini (2000) and Cagetti and DiNardi (2006) to include heterogeneous labor markets, as
in the “islands” economy of Lucas and Prescott (1974).17 The model also features indivisible
labor choice characterized by frictions between production and leisure “islands”, as in Krusell,
Mukoyama, Rogerson, and Sahin (2011).
There is a unit mass of infinitely-lived individuals. Time,  is discrete and all individuals
share the discount factor,  ∈ (0 1) Each period an individual is endowed with one unit of time,
which can be used for production as a worker or an entrepreneur. Individuals have identical
preferences represented by the period utility
(   ) = ln  −  
where  ≥ 0 is the consumption,   0 is the disutility from labor, and  ∈ {0 1} is an indicator
of participation in the labor market.
Each individual possesses an amount,  ≥ 0 of assets. Individuals also differ in their ability
(or productivity), both as a worker and an entrepreneur. Worker productivity is summarized by
  0—the efficiency units of labor an individual can supply in a period. The productivity,  
16
For simplicity, there is no transition of entrepreneurial firms to the corporate sector. A more realistic approach
would be to allow entrepreneurial firms to enter the corporate sector at some rate. However, it is not clear the
added complications would yield substantially different insights to the sorting of workers between the two types
of firms.
17
See also Alvarez and Veracierto (2000).
8
evolves over time independently across individuals according to the process
ln  =  ln −1 +  
(1)
 ∼ (0  )
Similar to the worker ability, the entrepreneurial ability,   also evolves independently across
individuals according to
ln  = (1 −  ) +  ln −1 +  
(2)
 ∼ (0  )
There are two sectors of production: a corporate and an entrepreneurial sector, denoted
by  ∈ { }, respectively. Production technology differs across the two sectors. There is a
representative firm in the corporate sector. It generates output,   by combining capital,  
and efficiency units of labor,   by way of a constant-returns-to-scale production technology

 =  1−

where  ∈ (0 1) and   0 is the corporate sector’s total factor productivity.
Each firm in the entrepreneurial sector is run by an entrepreneur with ability  , who uses
capital,   and efficiency units of labor,   to produce output,   via a decreasing-returns-to-scale
technology
 =  ( 1− ) 
(3)
where  ∈ (0 1) is a span-of-control parameter, which may reflect the diminishing returns to the
entrepreneur’s managerial ability.
There are two types of frictions. The first type is the search frictions in labor markets.
Employment opportunities for nonemployed individuals arrive every period with probability .
Job offers can come from the corporate sector or the entrepreneurial sector. The job offer
likelihood, however, varies across the two sectors. Conditional on the arrival of a job offer,
the offer is from the corporate sector with probability . Employed individuals maintain a
deterministic match to the sector for the duration of their tenure. There is no on-the-job search,
and individuals can receive job offers only when nonemployed. Every period workers can separate
from their employers voluntarily or involuntarily. An involuntary separation occurs for a worker
in sector  ∈ { } with probability,   When an individual is separated from a firm or when an
individual decides to quit entrepreneurship, the individual has to stay nonemployed for at least
one period before making the decision to work again. The parameters {     } govern the
frictions in the labor market.
The second type of friction is financial in nature. There are borrowing constraints for entrepreneurs. The amount of capital,   an entrepreneur with assets,   can access is bounded:
9
 ≤   where  ≥ 1 is an exogenously given borrowing limit. When  = 1 entrepreneurs can
only use their accumulated assets to finance production. The parameter  is the only parameter
that governs the financial frictions. Assets and capital earn an interest rate,   0 and capital
depreciates at a rate of  ∈ (0 1)
The timing of events within a period is as follows. Individuals first realize their current-period
labor productivity. Each nonemployed individual then receives a job offer from one of the sectors.
All individuals then make their decisions about whether to work, become an entrepreneur, or not
work. Following this decision, all entrepreneurs realize their current-period abilities and choose
their inputs for production. Each individual then chooses how much to consume and save. At
the end of the period, some of the employed individuals get separated from their employers
exogenously.
3.1
Individuals’ Problems
Consider a stationary environment where policies and payoffs do not depend on calendar
time. Let  = (  ) summarize an individual’s assets, and worker and entrepreneurial ability in
a period. In addition to  each individual is differentiated by current-period labor status, which
can be nonemployment (), working in the corporate sector ( ), working in the entrepreneurial
sector () or being an entrepreneur (). Similar to , define e = (  −1 ) to be the individual’s
assets, worker, and entrepreneurial ability, before the current-period entrepreneurial ability, 
is known. Note that e is identical to  except for its last element, which is the individual’s
previous-period entrepreneurial ability.
Consider now an individual who was a worker in sector  at the end of the previous period,
or who has a job offer from sector  in the current period. This individual faces the choice
between work, nonemployment, and entrepreneurship. This choice is made before the current
period entrepreneurial ability is realized, but with the knowledge of current worker ability and
assets. One can define the expected value of this individual as
  (e
) = max{E|−1 [  ()] E|−1 [  ()] E|−1 [  ()]}
(4)
Consider next an individual who was not a worker in any sector at the end of the previous
period, or who has no job offer in the current period. This individual faces the choice between
nonemployment and entrepreneurship and his value is given by
(e
) = max{E|−1 [  ()] E|−1 [  ()]}
(5)
Using (4) and (5), the value of a nonemployed individual can be written as
{ln  + E0 | [[  (e
0 ) + (1 − )  (e
0 )] + (1 − )(e
0 )}
  () = max
0
 ≥0
10
(6)
subject to the budget constraint
 + 0 = (1 + )
where e0 = (0   0  ) and (0   0 ) denotes the next period’s assets and worker ability. Equation
(6) reflects the fact that a nonemployed individual obtains the utility from consumption in the
current period, and in the next period the expected value depends on whether a job offer is
received, and the sector this offer comes from.
Denote by  the wage per unit of worker efficiency in sector  ∈ { } The value of an
individual who works in sector  is given by
{ln  −  + E0 | [(1 −  )  (e
0 ) +  (e
0 )]}
  () = max
0
 ≥0
(7)
subject to
 + 0 =   + (1 + )
The value in (7) is composed of two parts. An employed individual receives a current utility
from consumption that is reduced by the disutility of work. In the next period, the individual’s
expected value depends on whether he gets separated.
Finally, the value of an entrepreneur is
  () = max
{ln  −  + E0 | [ (e
0 )]}
0
 ≥0
(8)
subject to
 + 0 = () + (1 + )
where the entrepreneurial profit, () is given by
() =
max {( 1− )1− −   − ( + )
≥0;≤
(9)
The entrepreneurial value in (8) consists of the current period utility that results from consumption and work, and the next period’s expected value, which reflects the fact that in the next
period the individual can continue to be an entrepreneur or choose to be nonemployed.
3.2
Equilibrium
Let  ∈ {   } denote the labor status of an individual in any given period. In addition,
let  ∈ {   } be the “island” or “location” of the individual at the end of the previous
period. A stationary competitive equilibrium for the model is a collection of value functions,
  (), wage in each sector,  for  ∈ { } an interest rate,  labor supply rules,  (e
),
decision rules to become an entrepreneur,  (e
), saving and consumption rules, 0 () and  ()
an entrepreneur’s capital and labor utilization rules, () and (), and measures of individuals
by labor status, Ψ () such that
11
1. The labor supply rules,  (e
) and the decision rules to become an entrepreneur,  (e
)
solve the problems (4) and (5),
2. The saving and consumption rules, 0 () and  () solve the individuals’ problems defined
in (6), (7), and (8),
3. The interest rate,  and the corporate sector wage,   satisfy
 =  −1 1− − 
(10)
 = (1 − )  − 
(11)
4. The capital and labor choices, () and () solve the entrepreneur’s problem in (9),
5. The measures, Ψ () are consistent with the behavior of the individuals,
6. Labor, capital, and goods markets clear
Z
Z

()Ψ () = Ψ ()
=
+
Z
 +
Z
Z

Ψ ()
()Ψ () =
XZ


(entrepreneurial sector labor)
()Ψ () =
XZ

(corporate sector labor)
Ψ ()
µ
¶
Z

()Ψ () +   + ()Ψ ()

(12)
(13)
(capital)
(14)
(goods)
(15)
where () denotes the output of an entrepreneur with state .
While the corporate sector wage,   depends on the representative corporate firm’s labor
choice decision (11), the entrepreneurial sector wage,   is the value that equates the labor
demand by all entrepreneurs to the labor supply of all workers in the entrepreneurial sector—
equation (12). The amount of capital used by the corporate sector and the entrepreneurial firms
must equal the total assets of all individuals in the economy, as ensured by (14). Finally, the
total output in the economy must account for the total consumption by individuals and the
replacement of the depreciated capital, as stated in (15). Appendix A outlines the algorithm
that is used to solve for the stationary equilibrium numerically.
12
4
Calibration
The parameter values used in the calibration of the baseline model are in Table 3. Each
period corresponds to one quarter. The discount rate,  is set to 0985, to match an annual
interest rate of 4%. The process for labor productivity,  in (1) has the parameters {    } =
{097 013}, based on Heathcoate, Storesletten, and Violante (2010).
The annual values of the parameters {    } of the process for managerial ability  in (2) and
the returns-to-scale parameter,  are estimated separately for entrepreneurial firms (firms aged 0-
5 years) versus non-entrepreneurial firms (firms aged 6+ years) in the manufacturing sector. The
data unavailability precludes the estimation of these parameters for firms in other sectors of the
economy. The estimation is based on the econometric methodology used in Abraham and White
(2006), which allows joint estimation of the parameters {     }, as described in Appendix B.
For entrepreneurial firms, the estimated parameters for the entrepreneurial ability process for 
are {    } = {03 018} which are the averages across narrowly defined industries at the level
of 4 digit SIC codes. For entrepreneurial firms, the span-of-control parameter,  has an average
estimated value of 088 across industries. This value is smaller than the corresponding one for
non-entrepreneurial firms (around 097), suggesting a lower span-of-control for entrepreneurial
firms.
Following Kitao (2008) and Buera and Shin (2011), the borrowing constraint parameter, 
is set to 15, implying that an entrepreneur can borrow up to 50% of his assets at the beginning
of the period. Based on the business-cycle literature, the capital’s share of output,  is set to
036 and the quarterly depreciation rate,  is taken to be 0015 which corresponds to an annual
depreciation rate of 006. The productivity of the corporate sector, , is normalized to exp(−1)
The remaining vector of parameters, {       } are chosen to hit six different targets
that constitute a system of non-linear equations. While these equations are simultaneous in
nature and involve all relevant parameters of the model, each equation plays an instrumental
role in setting a specific parameter. The values of the targets are chosen to be the average
value of the empirical counterparts for the period 1999-2001 For the disutility of labor,  the
key target is the employment-to-population ratio (086) among individuals aged 25-64 years.
Two other targets, the share of employment in non-entrepreneurial firms (88%) and the average
worker earnings premium for these firms (33%), are important in pinning down the value for the
job offer rate from the corporate sector,  and the separation probability from entrepreneurial
sector employment,  . The job finding rate,  and the job separation rate from corporate sector
employment,  , are set so that aggregate job separation rate (employment-to-nonemployment
flows) is 19% as a fraction of total employment, and the job finding rate (nonemployment-toemployment flows) is 45%. Finally, the fraction of entrepreneurs, 31% is targeted in assigning
13
a value to the productivity parameter,  The fraction, 31% is obtained from the compilation
of estimates based on a wide-range of definitions and sources in Table 2.
5
Properties of the Baseline Model
The key features of the calibrated model’s equilibrium are shown in Table 4. The model
does a reasonable job in matching the targeted values. It produces an employment-to-population
ratio of 086, consistent with its targeted value. Around 36% of the individuals choose to become
entrepreneurs, a figure slightly higher than the targeted fraction of 31%, but within the range
of various estimates in Table 2. As shown in Figure 1a, the individuals with a higher level of
entrepreneurial ability tend to become entrepreneurs. Those who become entrepreneurs also tend
to accumulate higher levels of assets, as shown in Figure 1b. Furthermore, entrepreneurs exhibit
variation in their capital input, which has a skewed distribution as shown in Figure 1c. The
distribution of the labor input (in efficiency units) for the entrepreneurial firms shown in Figure
1d is also highly-skewed.18 The features of the model discussed so far are shared by those of the
other models in recent work, indicating that the model is able to capture the salient aspects of
these models.19
The model’s main distinguishing aspect, heterogeneous labor markets, enables it to provide
further insight to the functioning of the labor markets and the nature of worker sorting. The
calibration model’s equilibrium generates patterns that are broadly consistent with the behavior
of the key metrics for the U.S. labor market. For example, in the baseline model, 11% of the
employees work for young firms, close to the value of 12% in the data, as seen in Table 4. The
model also delivers a corporate earnings premium consistent with the data. The average worker
earnings in the corporate sector is about 32% higher than that in the entrepreneurial sector,
almost identical to the targeted value of 33%. Note that the average earnings in each sector
depends on the distribution of worker productivity () in each sector, as well as the wages per
efficiency units of labor (   ). The values for  and  are obtained in the calibrated model’s
equilibrium, but there is no observable target to discipline their values. The wage per efficiency
unit of labor in the corporate sector,   turns out to be 060, as opposed to  = 058 in
the entrepreneurial sector. In other words, the corporate sector offers about 3% higher wage
per worker efficiency unit. The average worker productivity, on the other hand, is significantly
higher in the corporate sector (164) than in the entrepreneurial sector (128). That is, a worker
18
This shape is in line with the typical shape of the firm-level distributions of labor input in empirical studies.
However, note that the labor input in the model (worker efficiency units) is different from the employment measure
(the number of workers) typically used in empirical studies of firm size.
19
See, e.g., Quadrini (2000), Cagetti and De Nardi (2004), Kitao (2008), Buera and Shin (2011), Buera, FattalJaef, and Shin (2015), and Bassetto, Cagetti, and De Nardi (2015)
14
in the entrepreneurial sector is about 78% as productive, on average, as a worker in the corporate
sector. This sorting of individuals based on productivity drives in part the corporate earnings
premium.
The model is calibrated to match the aggregate job finding rate (45%) from unemployment,
as well as the job separation rate from employment (19%). The calibrated model’s equilibrium
is broadly consistent with the magnitude of these worker flows in the data—see, again, Table
4. However, a key question is whether the model is able to also capture these flows by firm
type (entrepreneurial and non-entrepreneurial) as well, which are not explicitly targeted in the
calibration. Table 4 details the magnitude of sector-specific flows as a share of the total flows,
and compares them with their counterparts in the data. The model captures the magnitude of
flows across by firm type quite well. In particular, in the data 21% of flows to nonemployment
originate in entrepreneurial firms, and the model captures these flows closely (22%). Likewise,
23% of flows into employment go to entrepreneurial firms, as opposed to the model’s figure
of 16%. The model’s ability to approximate the shares of flows into and out of employment
accounted by entrepreneurial firms suggests that the model generates the appropriate amount of
incentives for work among individuals facing employment prospects in entrepreneurial firms.
Figure 2a illustrates how individuals at any given productivity level are allocated across the
two sectors and entrepreneurship. As worker productivity increases, the fraction of individuals
who work in the corporate sector increases, whereas the fraction of those who are entrepreneurs
declines. However, the fraction that is employed in the entrepreneurial sector first decreases,
and then starts to increase at higher levels of productivity. As discussed further below, this nonmonotonicity is driven by how the distribution of assets across workers influences their decision
to work in the entrepreneurial sector.
If entrepreneurial firms pay lower wages per efficiency unit, why does anyone work for them
at all? Figure 2b shows the distribution of workers’ assets in the entrepreneurial and corporate
sectors. The distribution in the entrepreneurial sector is much more skewed, with a high mass
over the range of low asset levels. Table 4 indicates that average assets of the workers in the
corporate sectors is nearly twice that of the workers in the entrepreneurial sector. When only
the workers in their first quarter of a job is considered, the average assets for workers in the
corporate sector is about 15 times that of those in the entrepreneurial sector—see Figure 2c.
That is, there is a wealth differential not only between the workers in the two sectors, but also
between the workers who have just accepted jobs in these two sectors. The assets ratios in the
model are close to the figures that arise from the empirical analysis discussed in Section 6, as
the estimates shown in Table 4 next to their model counterparts confirm. Because nonemployed
individuals with low assets are not wealthy enough to secure a smooth stream of consumption
while unemployed, they cannot afford to reject a job offer from the entrepreneurial sector and
15
wait for a job offer from the corporate sector. In other words, the opportunity cost of waiting
for a corporate offer is high for these individuals.
Figure 2d shows what types of individuals accept a job offer from the entrepreneurial versus corporate sector. The figure illustrates how the acceptance regions for entrepreneurial and
corporate offers vary by worker productivity and assets. As an individual’s assets increase, the
threshold productivity for accepting a corporate sector job offer increases. Note also that, given
a level of assets, the productivity threshold for accepting a corporate sector offer always lies
below the one for an entrepreneurial sector offer. In other words, individuals that take jobs in
the entrepreneurial sector tend to be more productive. On the one hand, the wage differential
provides a higher return to work for the corporate sector and generates an incentive for individuals to wait for a job offer from this sector. On the other hand, the higher job separation rate
in the corporate sector suggests that the return to work in corporate sector cannot be too large
conditional on a job offer.
Another notable feature in Figure 2d is that for an entrepreneurial job offer there is a part
of the rejection region that protrudes into the acceptance region. This extra rejection region
indicates a non-monotonicity in the decision rule to accept employment in the entrepreneurial
sector. No such region exists for the decision rule for corporate sector work. Figure 2e shows the
acceptance region for becoming an entrepreneur at the median managerial ability, . This figure
indicates that individuals would not choose to become entrepreneurs inside the extra rejection
region of Figure 2d. In other words, individuals who are in this extra rejection region reject a
job offer from the entrepreneurial sector in favor of continuing to be nonemployed and waiting
for another job offer.
One way to understand further the nature of this extra rejection region is to examine the value
functions for an individual with median entrepreneurial ability and median labor productivity.
These value functions are plotted in 3b and 3c. Figure 3b shows the value functions over a broad
asset range, whereas Figure 3c zooms in to the region where the value of leisure exceeds that
from entrepreneurial work. This region is small, but it is important to understand its source.
To do so, consider the entrepreneurship choice in a partial equilibrium setting. Holding prices
(    ) fixed at their baseline values, suppose entrepreneurship was no longer available as a
choice. What would the optimal decision rule look like for an individual with an entrepreneurial
sector offer? Figure 3d shows this decision rule for an individual with median managerial ability.
In this partial-equilibrium setting, individuals are much more choosy about accepting a job in the
entrepreneurial sector. The main reason is that an incentive to work in order to accumulate assets
to finance a potential entrepreneurial project in the future is now missing. In other words, there
is no incentive to accumulate capital outside the precautionary savings motive. As a result, the
threshold productivity at which individuals would choose to work is higher than in the baseline
16
economy.
Now consider an economy with an entrepreneurial choice, but without any uncertainty in
managerial ability at the time the entrepreneurship choice is made. That is, suppose that the
timing is such that  and  are both realized at the beginning of the period. The return to
becoming an entrepreneur is now known before the entrepreneurship decision is made. The
dashed line in Figure 3d represents the acceptance threshold in such an economy with prices
fixed again at their baseline values. In this economy individuals have a lower threshold for
accepting employment opportunities, compared with the baseline economy. In particular, the
extra rejection region in the baseline economy disappears. An individual with a realization of
assets and productivity in the extra rejection region rejects a job in the entrepreneurial sector,
but accepts such a job in an economy without uncertainty. The reason is that the uncertainty in
the scale of the project reduces the ex-ante return to working to accumulate assets to potentially
start a business in the future.
6
Evidence on Worker Sorting by Assets
A key prediction of the baseline model is the difference in the average asset holdings of
workers in the entrepreneurial versus the corporate sector. This difference emerges as a result
of the sorting of workers into sectors based on both productivity and wealth. Workers holding
fewer assets tend to accept job offers from the entrepreneurial sector. At the same time, workers
employed in the corporate sector tend to be more wealthy, because the higher wage in that
sector allows them to accumulate more assets. Is this sorting consistent with what is observed
in the data available? Unfortunately, household survey data that include information on assets
typically do not contain information on the age of a worker’s employer. Towards addressing this
shortcoming, the wealth data for workers in the Survey of Income and Program Participation
(SIPP) are merged with the LEHD data that captures employer-specific characteristics for those
workers. In particular, the responses from the Asset and Liabilities Topical Module collected in
several waves of the 2008 SIPP Panels are used to create a net worth variable, excluding housing
equity.20 The net worth variable is calculated at the household level and used as the empirical
counterpart to worker assets in the model. The workers in the SIPP sample are linked to the
LEHD data. For workers holding more than one job during the relevant quarter, firm age
pertains to the firm where worker earnings were the greatest among all jobs held in that quarter.
The sample is also restricted to prime age males with ages 25-54 who are not entrepreneurs, to be
consistent with the baseline model’s calibration. That is, the sample excludes those individuals
20
The 2008 Panel was chosen to maximize the number of possible linkages with LEHD data due to limited state
data availability.
17
whose sector-of-employment choices might be influenced by schooling decisions, fertility decisions,
and the timing of retirement.
The top panel of Table 5 shows the mean and median net worth statistics by firm age. Both
measures indicate a stark difference in asset holdings of workers at young firms relative to others.
In particular, workers in older firms have an accumulated asset stock that is 50 percent to more
than 200 percent higher than those of the workers in younger firms. While calculation of other
moments is not feasible with the available data due to small sample sizes, it is also noteworthy
that a larger fraction of the workers in younger firms are net borrowers, and claim zero or negative
net worth compared with the workers in more established firms.
It is important to note that higher wages in older firms relative to young firms would imply
an asset differential even in the absence of sorting, as long as employment has some persistence.
More direct evidence on sorting of workers based on assets can be seen by examining average and
median assets of new workers only. For this purpose, the sample is restricted to those workers
who are in the first quarter of their employment spell, based on the information on the quarter
of employment in the LEHD data. This subsample allows for an approximation to the asset
holdings of workers who transition into employment. The results are again shown in Table 5.
There is a large net worth differential across workers in the two types of firms when measured
by either the mean or median asset holdings.
The bottom panel of Table 5 shows the extent to which worker sorting prevails when firm
size is used instead of firm age to define entrepreneurial firms. Although the results are generally
weaker, the net worth differential remains for the median asset holdings, with a slightly smaller
magnitude. In particular, the median worker in larger firms has net worth of $20,642 compared
with $9,397 in smaller firms. Finally, as a check of the representativeness of the SIPP subsample
relative to the more aggregated statistics in Table 2, average worker earnings are calculated by
firm age. The average earnings premium in the larger sample is 24%, versus 15% in the restricted
sample. Both figures are within the range of estimates in Table 2.
7
Experiments
This section analyzes how the properties of the model’s equilibrium respond to changes in
the key parameters. The approach is to change each key parameter from its baseline value one
at a time, and compare the resulting equilibrium with the baseline. There are two motivations
for this exercise. The first one is to understand the workings of the model in further detail:
What kind of changes occur in the model’s properties as one of the key parameters changes?
The second one is to assess the model’s ability to generate some of the trends for entrepreneurial
firms in the last couple of decades: What kind of changes in the parameters lead to a decline in
18
the entrepreneurial sector of the model economy that is qualitatively consistent with the trends
observed in the data? Some of these trends are summarized in Figure 4, which highlights various
dimensions of decline in entrepreneurial activity. The number of young firms has been stagnant,
even as the number of established firms grew (Figure 4a); the share of employment accounted by
young firms has been falling (Figure 4b); the relative average worker earnings in young firms has
been decreasing (Figure 4c); and the average size of young firms, as measured by employment,
has been shrinking relative to that of established firms (Figure 4d).21
There are many potential explanations for the observed decline in entrepreneurship. One
hypothesis is that changes in workers’ job search technologies and firms’ vacancy posting technologies altered labor market frictions in a way to put entrepreneurial firms at a disadvantage
relative to larger, more established firms.22 In relation to this hypothesis, lower worker mobility
across firms, particularly for younger workers, has accompanied the decline in entrepreneurship.
Given the evidence that young firms disproportionately draw their labor force from young and
nonemployed individuals, the two trends are not independent. Increasing labor market frictions
may have made it more difficult for young firms to attract the type of workers who would work
for them.
Another potential reason behind the decline is increasing financial frictions for entrepreneurs.
Recent research has focused on various implications of a tighter credit environment for businesses
created by the onset of the Great Recession.23 In addition to impeding entry, an increasingly
limited amount of credit can also lead entrepreneurs to operate below their efficient scale by
inhibiting business expansion. However, it is important to emphasize that in the longer run,
such constraints may have actually become less restrictive as a result of the changes in the
financial sector. Thus, the effect of the financial environment for entrepreneurs may be different
in the long- versus short-run.
Another hypothesis for the decline has to do with the supply of entrepreneurs. Some policies
that curb the availability of able entrepreneurs may contribute to the underwhelming performance
of the entrepreneurial sector.24 Similarly, increasing costs of education, training, and more
21
The average size is measures by the total employment in young firms divided by the number of young firms.
This measure has the obvious counterpart in the model as both the mass of entrepreneurial firms and the mass
of individuals working for them are available, even though the size of entrepreneurial firm is defined in efficiency
units of labor and the number of employees for entrepreneurial firm is thus indeterminate.
22
See Decker, Haltiwanger, Jarmin, and Miranda (2014a) for a discussion. Recent work on these issues include
Cairo (2013), who analyzes the role of increasing training costs on job reallocation.
23
See, for instance, Haltenhof, Lee, and Stebunovs (2012) for a study of the effects of tighter bank lending on
consumers and firms. Other channels, such as the effects of the reduced housing assets of consumers who are
potential entrepreneurs, have also been explored. See Decker (2014) for an analysis of this channel.
24
For instance, Hathaway and Litan (2014b) argue that immigration policy in the U.S. may have limited the
supply of skilled entrepreneurs.
19
generally, human capital accumulation, can also reduce the pool of skilled entrepreneurs. Changes
in the broader business climate (e.g. laws and regulations, taxes and other policies) may also
have adversely affected new business formation and expansion. Demographic shifts in the form
of an aging U.S. population may have also played a part in the declining dynamism of the
entrepreneurial sector.25
The experiments with the parameters of the model aim to understand the relevance of some
of the hypotheses discussed above. The results of the experiments are collected in Table 6. It is
important to note that the exercises below do not constitute an attempt to quantitatively match
the trends in the entrepreneurial sector. In interpreting the results, the exact magnitudes of the
changes in the key metrics for the entrepreneurial sector from their baseline values is not the
focus. In particular, the parameter values used in the experiments are not chosen to match any
of the trends quantitatively. An analysis of the contribution of different channels to the decline
in entrepreneurship is left for future work.26 The more modest goal here is to understand what
factors in the model are capable of getting right the directions of change in various performance
metrics for the entrepreneurial sector.
7.1
Labor Market Frictions
7.1.1
Job Finding Rate
In the baseline model, the implied job offer probability is  = 056. In this experiment, the
job finding rate is also assigned the values in the set {02 03 06 08} to explore the effects of
a change in the frictions in job finding. A lower value of  implies that jobs are more scarce,
and it takes longer on average for a nonemployed individual to receive a job offer. This effect
decreases the return to work, and hence, the number of individuals who choose to work. As a
result, wages need to be higher to attract workers, leading to a rise in the cost of entrepreneurship
and a decline in the return to entrepreneurship. As shown in Figure 5a, the fraction of workers
in the entrepreneurial sector decreases as job finding rate decreases. There is also a decline in
entrepreneurship. At the same time, Figure 5b indicates that as  falls both the wage and average
earnings in the entrepreneurial sector decline relative to their counterparts in the corporate sector
for almost the entire range of values experimented with. Average labor productivity and average
assets of workers in the corporate sector relative to the entrepreneurial sector, both pictured in
Figure 5c, increase as  falls, with the exception of going from 03 to 02 Similar patterns apply
25
For the connection between aging and entrepreneurship, see, e.g., Liang, Wang, and Lazear (2014), who find
a significant negative effect of aging on business formation rate across countries.
26
One avenue for future work is to uncover how much a given parameter needs to change to generate the exact
magnitudes of decline in the key metrics for the entrepreneurial sector.
20
when only the workers in their first quarter of a job is considered—see Figure A5c in Appendix.
Average employment in the entrepreneurial sector, as measured by the number of workers per
firm, tends to increase as  falls from 08 to 02 again except for the decline that takes place
from 03 to 02 (Figure 5d). This experiment demonstrates that a drop in the arrival rate of
job offers around its baseline value is capable of generating the observed directions of change in
many aspects of entrepreneurship.
7.1.2
Job Offer Rate from the Entrepreneurial Sector
In the baseline case, a nonemployed individual receives an offer from the corporate sector
with probability 075 giving the corporate sector some advantage in hiring. In this experiment,
the likelihood that an offer comes from the corporate sector is assigned several additional values
in the range {01 03 06 08 095}. This experiment explores the possibility that increasing frictions in hiring for entrepreneurial firms may lead to a decline in entrepreneurship. For instance,
increasing dominance of large, established firms in the labor market and their advanced hiring
technologies may reduce access of entrepreneurial firms to workers. A decline in the job finding
rate in the entrepreneurial sector (a higher ) has a negative effect on the fraction of entrepreneurs
in the economy, as seen in Figure 6a. Note, however, that an increase from the baseline value,
075 to 095 leads to only a small decline in the fraction of entrepreneurs. Similarly, the share
of employment in the entrepreneurial sector shrinks. The corporate earnings premium declines,
along with the wage per efficiency unit for workers relative to that in the entrepreneurial sector
(Figure 6b). When entrepreneurial sector jobs are harder to find (higher values of ), the sector
has to offer a higher wage per efficiency unit to attract workers, which results in higher average
worker earnings in the entrepreneurial sector. Because the wages in the two sectors get closer
to each other as  increases, workers are more evenly distributed across the two sectors based
on average worker productivity and assets, as shown in Figure 6c. A similar pattern applies to
the case of workers in their first quarter of employment—see Figure A6c in Appendix. Note also
that average employee size of a firm in the entrepreneurial sector tends to decline for values of
 beyond 06—Figure 6d. This experiment captures qualitatively some of the features that the
entrepreneurial sector in the United States exhibited in recent years. As  increases, the decline
that takes place in the rate of entrepreneurship and the share of employment in the entrepreneurial sector is consistent with the observed trends. What is not consistent with the trends,
however, is the erosion of the corporate earnings premium that accompanies an increase in 
21
7.1.3
Job Separation Rate in the Entrepreneurial Sector
Suppose now that the separation rate in the entrepreneurial sector,   increases gradually
from its baseline value of zero to 006 The values of  experimented with are {0003 0006 001 003 006},
in addition to the baseline value of zero. Recall that the separation rate in the corporate sector
for the baseline model is 0006 The goal of this experiment is to assess the effect of job tenure
becoming more temporary in the entrepreneurial sector. As shown in Figure 7a, in response to
an increase in the separation rate the fraction of entrepreneurs declines, and the share of employment in the entrepreneurial sector also goes down. The corporate earnings premium falls for
lower values of  , but increases for higher value of  ; see Figure 7b. As jobs have a much shorter
tenure in the entrepreneurial sector, the relative productivity of workers in the entrepreneurial
sector also goes down for most of the values experimented with (Figure 7c). In addition, the
relative average assets of workers in the entrepreneurial sector tend to be higher for high values
of  , after a drop for low values of   Similar conclusion applies to the average assets of workers
in their first quarter of employment—see Figure A7c in Appendix. Finally, the average size of an
entrepreneurial firm initially declines as the separation rate increases, but then rises and does not
change much for higher values of the separation rate (Figure 7d). While a rise in the separation
rate in the entrepreneurial sector leads to a decline in entrepreneurship, many of the key metrics
(average earnings ratio, average assets ratio, and average employment) are non-monotonic over
the range of values considered.
7.2
Financial Frictions
In this experiment, the amount of borrowing is assigned values in the set {1 125 2 5 10}
in addition to the baseline value of  = 15 The case  = 1 corresponds to an economy with
no borrowing. Higher values of  correspond to increasingly relaxed borrowing constraints. It is
important consider a wide-range of values for the borrowing parameter  given that the literature
on entrepreneurship has mainly relied on a limited set of values and estimates for this parameter.
The effect of reducing borrowing to  = 1 from its baseline value is pronounced for all aspects
of entrepreneurship, as shown in Figure 8a. No borrowing discourages entrepreneurship, and the
fraction of entrepreneurs falls. There is also an accompanying fall in the share of employment
in the entrepreneurial sector. Higher values of the borrowing limit leads to higher rates of
entrepreneurship and higher employment in the entrepreneurial sector, but the marginal effect of
increasing the borrowing limit declines fast, with little additional effect going from  = 5 to  = 10.
The corporate earnings premium also increases sharply in response to a fall in the borrowing limit
from its baseline value—Figure 8b. Higher borrowing limits allow the entrepreneurial sector to
offer a wage close to that in the corporate sector, and the earnings differential between the two
22
sectors shrinks. As the borrowing limit increases, the gap between the average assets for workers
in the two sectors also becomes smaller, as shown in Figure 8c. Figure 8c also indicates that the
average labor productivity in the entrepreneurial sector declines as the borrowing limit increases,
relative to that in the corporate sector. A similar picture emerges when the average assets of
workers in their first quarter of employment—see Figure A8c in Appendix. A relaxing of the
borrowing constraint also implies that the average size of an entrepreneurial firm increases for
most of the range of values considered for —see Figure 8d. When borrowing is less constrained,
more entrepreneurs are able to achieve their optimal scale. Overall, this experiment suggests
that tighter financial constraints entrepreneurs face in the aftermath of the Great Recession may
have relevance in accounting for some of the recent changes observed for entrepreneurship in the
United States.
7.3
Entrepreneurial Ability
To assess the implications of a reduction in the quality of entrepreneurs, this experiment
changes the average entrepreneurial productivity, exp(), over the range (040 060) around its
baseline value of 046 The changes are implemented as first-order stochastic shifts in entrepreneurial ability, that is, as a shift in the mean of the distribution of ability, but no change in its
variance. As pictured in Figure 9a, a degradation in the average quality of entrepreneurs leads to
a lower fraction of entrepreneurs in the economy. The share of employment in the entrepreneurial
sector also falls. Corporate earnings premium increases substantially, even though the relative
wage remains fairly stable—Figure 9b. The different patterns for wages and average earnings
suggest that the selection of the individuals into the two sectors is now more pronounced. This
selection is highlighted in Figure 9c. The ratio of average assets of workers in the corporate
sector to those of the workers in the entrepreneurial sector goes up when entrepreneurial ability
declines. The average productivity of workers in the entrepreneurial sector also increases, in
a relative sense. In other words, a degradation in the average quality of entrepreneurs is accompanied by a degradation in the average quality of workers who work for them relative to
those in the corporate sector. Again, these patterns continue to hold when only the workers in
their first quarter of employment are considered—see Figure A9c in Appendix. Somewhat surprisingly, average employment of an entrepreneurial firm becomes lower as the entrepreneurial
ability improves—Figure 9d. This is driven by the fact that the average productivity of workers in
the entrepreneurial sector also rises as entrepreneurs become more able, leading an entrepreneur
to hire fewer (but more productive) employees on average. In summary, as in the case of a tighter
borrowing limit, a decline in the average productivity of entrepreneurs is capable of mimicing
qualitatively some facets of the decline in entrepreneurship.
23
8
Conclusion
Entrepreneurial firms, which tend to be young and small, typically hire younger workers
who disproportionately come from the ranks of nonemployment and provide lower earnings to
these workers. Furthermore, in recent years the number, the employment share, and the worker
earnings of such firms have all declined. To understand these facts further, this paper proposed
a dynamic model of entrepreneurship, which features labor markets for two different sectors, the
entrepreneurial and the corporate sector, with different search frictions. The sectors also have
different production technologies and financial constraints. The corporate sector approximates
the set of firms that have largely overcome managerial and financial constraints. The differences
in labor market frictions, production technologies, and financial frictions lead to different sectoral
wages per unit of worker efficiency, which results in a sorting of workers across the two sectors.
The calibrated model’s equilibrium offers an answer to the central question of who works for
whom. Among individuals who are looking for work, less wealthy ones more readily take up job
offers from the low-paying entrepreneurial sector, instead of waiting for a corporate job offer.
This mechanism results in a sorting of individuals across the two sectors based on both wealth
and productivity. The model can account for the observed differences in the employment shares
and the average earnings of workers in the two sectors, as well as the differences in flows from
and to nonemployment from these sectors. The model’s key prediction that workers sort based
on assets into the sectors also finds support in the data. Both the workers in young firms and
those who are in their first quarter of tenure in young firms possess, on average, lower assets
than workers in more established firms.
As an application of the model, potential mechanisms behind the recent decline in entrepreneurial activity in the United States are explored qualitatively by altering the key parameters
of the model and comparing the resulting equilibria with the baseline. Two conclusions emerge
from the experiments. First, the model is able to generate plausible equilibrium values for key
variables of interest over a wide range of values for each parameter. Second, the experiments
indicate that a variety of channels, including an increase in financial frictions or a decline in the
quality of entrepreneurs, can qualitatively generate many of the observed trends. While these
experiments are promising in terms of identifying potential channels at work, they are not meant
to capture the quantitative aspects of the decline in entrepreneurship, or identify the most important channel. A challenge for future work is to quantify the contribution of each potential
channel to the decline in entrepreneurship.
24
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27
Table 1. Some facts about entrepreneurial firms
Young Firms
Small Firms
(0-5 years of age)
(≤ 20 employees)
Metric
1987 2000 2012 1987 2000 2012
Share of firms
048
041
033
090
089
090
Share of employment
021
016
011
021
019
018
Relative median of the firm-level average earnings
079
085
075
072
073
076
Relative average firm employment
028
026
025
003
003
002
Share of hires from nonemployment
—
024
026
—
026
027
Share of separations to nonemployment
—
021
023
—
026
027
Relative share of hires from nonemployment
—
105
104
—
120
118
Relative share of separations to nonemployment
—
103
105
—
124
120
Notes: The data sources are Longitudinal Business Database (LBD) and Longitudinal Employer-Household Database
(LEHD). A young firm is defined as one that is 0-5 years old. A small firm is defined as one that has at most 20
employees. “Relative” indicates that the value is expressed relative to that of the rest of the firms.
Table 2. Alternative measures of the fraction of entrepreneurs in the economy in 2000
Fraction of
Basis
Non-entrep. Firm Employment
entrep.
Pay Premium
Share
Young and small firms (0-5 yr & emp ≤ 7)
11%
208%
36%
LBD
13%
185%
59%
LBD
Young firms (0-5 yr)
14%
172%
157%
LBD
Young firms + small old firms (6+ yr & emp ≤ 7)
31%
397%
208%
LBD
Young firms + small old firms (6+ yr & emp ≤ 15)
35%
447%
254%
LBD
Small firms (emp ≤ 10)
31%
335%
118%
LBD
Small firms (emp ≤ 20)
35%
367%
186%
LBD
Small firms (emp ≤ 25)
36%
374%
210%
LBD
Young firms (0-10 yr)
20%
166%
248%
LBD
Young firms + small old firms (11+ yr & emp ≤20)
37%
498%
331%
LBD
Firms classified with certainty as non-public
38%
452%
440%
SBO
Business owners with employees (Males 25-64)
29%
NA
NA
SIPP
Business owners with employees (Males 25-54)
28%
NA
NA
SIPP
Business owners with employees
24%
NA
NA
SIPP
Business owners with employees (All 25-54)
23%
NA
NA
SIPP
Young and small firms (0-5 yr & emp ≤ 15)
Notes: The data sources are Longitudinal Business Database (LBD), Survey of Business Owners (SBO), and Survey of Income and Program
Participation (SIPP). Estimates pertain to the year 2000. The denominator used to calculate fraction of entrepreneurs is the population 25-64
years of age unless indicated otherwise. The calculations assume that each entrepreneurial firm is owned by a single entrepreneur.
Source
Table 3. The parameter values for the baseline model
Parameter
Value
Target/Source
Disutility from labor, 
066
Fraction employed—25-64 yrs old males (086)
Discount rate, 
0985
Annual interest rate (004) (Business cycle literature)
Job separation rates, {   }
Job offer rate, 
Corporate sector job offer rate, 
Labor productivity, {    }
Entrepreneurial ability (Persistence), {    }
Entrepreneurial ability (Mean), 
{0000 0006} Separation rate from employment (19%)
056
Job finding rate from unemployment (45%)
075
Share of employment in the corporate sector (088)
{097 013}
{030 018}
Heathcoate et al. (2010)
Estimated based on Abraham and White (2006)
037
Fraction of entrepreneurs (31%)
Productivity of the corporate sector, 
036
Normalization
Borrowing limit, 
150
Kitao (2008)
Capital share in production, 
036
Business cycle literature
Capital depreciation rate, 
006
Annual depreciation rate
Returns-to-scale in entrepreneurship, 
088
Estimated based on Abraham and White (2006)
Notes: See Appendix B for the estimation of returns-to-scale for entrepreneurship and the parameters for the entrepreneurial ability
process. Job separation and finding rates are based on the Longitudinal Employer-Household Database (LEHD). Fraction of entrepreneurs
is based on the estimates in Table 2.
Table 4. The properties of the baseline model
Variable
Model Data
Employment-to-population ratio
086
086
Share of employment (Entrepreneurial)
011
012
Fraction of entrepreneurs
0036
0031
Average worker productivity (Corporate)
164
NA
Average worker productivity (Entrepreneurial)
128
NA
Corporate average earnings premium
033
032
Share of E-to-N transitions (Entrepreneurial)
022
021
Share of N-to-E transitions (Entrepreneurial)
016
023
Interest rate, 
0010
0010
Wage per efficiency unit,  (Corporate)
060
NA
Wage per efficiency unit,  (Entrepreneurial)
058
NA
Ratio of average worker assets (Corporate/Entrepreneurial)
192
150
Ratio of average worker assets in first quarter of job (Corporate/Entrepreneurial)
149
157
Notes: Employment-to-population ratio is based on the population 25-64 years old. Share of employment in the
entrepreneurial sector and corporate earnings premium are based on the Longitudinal Business Database (LBD).
Fraction of entrepreneurs is based on the estimates in Table 2. The estimates for average worker assets are based
on Survey of Income and Program Participation (SIPP)—see Section 6. E-to-N and N-to-E transitions are based
on the Longitudinal Employer-Household Database (LEHD).
Table 5. Household net worth by firm age and size
Household Net Worth
Mean
Median
Firm Age:
0-5 Yrs.
6+ Yrs
0-5 Yrs.
6+ Yrs
Net Worth (All)
$79 019
$118 192
$6 950
$18 657
(6 019)
(5978)
(885)
(633)
282%
211%
(052)
(019)
2 110
23 827
2 110
23 827
$42 410
$66 740
$4 930
$5 820
(4 411)
(3 189)
(1 053)
(772)
337%
309%
(131)
(071)
306
1 385
306
1 385
$9 680
$12 053
$6 994
$9 348
(172)
(74)
(180)
(94)

2 110
23 827
2 110
23 827
Earnings (At first quarter of job)
$5 773
$6 650
$3 270
$4 002
(362)
(128)
(273)
(162)
306
1 385
306
1 385
- Fraction with non-positive net worth

Net Worth (At First Quarter of Job)
- Fraction with non-positive net worth

Earnings (All workers)

Firm Size:
 50 Emp. 50+ Emp.  50 Emp.
50+ Emp.
$121 349
$113 061
$9 397
$20 642
(13 570)
(5 981)
(551)
(839)
255%
207%
(038)
(021)
6 131
19 806
6 131
19 806
$54 592
$66 069
$5 011
$6 049
(4 289)
(3 523)
(845)
(726)
320%
311%
(112)
(078)
540
1 151
540
1 151
$9 255
$12 639
$7 221
$9 896
(120)
(84)
(89)
(102)

6 131
19 806
6 131
19 806
Earnings (At first quarter of job)
$5 257
$7 066
$3 404
$4 124
(222)
(149)
(236)
(149)
540
1 151
540
1 151
Net worth (All workers)
- Fraction with non-positive net worth

Net worth (At first quarter of job)
- Fraction with non-positive net worth

Earnings (All workers)

Notes: Standard errors in parentheses. The data sources are Longitudinal Employer-Household Database (LEHD), and Survey
of Income and Program Participation (SIPP).
a. The distribution of managerial ability
c. The distribution of capital input
b. The distribution of assets
d. The distribution of labor input
Figure 1. The distributions of entrepreneurial ability, assets, capital input and labor input – baseline model
a. The allocation of individuals by labor productivity
c. The distribution of assets for workers in first quarter of employment)
b. The distribution of assets for workers
d. The decision rules for accepting a job offer (at median θ)
Figure 2. Allocation of individuals, distribution of assets, and decision rules – baseline model
d. The decision rules to become an entrepreneur (at median θ)
b. Individuals’ values as a function of assets
c. Individuals’ values as a function of assets (zoomed in)
d. The decision rules for accepting a job offer in the entrepreneurial
sector (at median θ)
Figure 3. Individuals’ values and decision rules – baseline model
a. The number of firms (in millions)
0.3
4
3
mature
2
b. Employment share of young firms
0.2
young
0.1
1
0
1982
1987
1992
1997
2002
0
1980
2007
c. Median of the average workers earnings (young‐to‐mature firm ratio)
1985
1990
1995
2000
2005
2010
2015
d. Average employment in young firms
9.50
0.9
8.50
0.8
7.50
0.7
0.6
1980
1985
1990
1995
2000
2005
2010
2015
6.50
1980
1985
1990
1995
2000
2005
Figure 4. Various dimensions of decline of entrepreneurial firms in the U.S.
2010
2015
a. Allocation of individuals
c. Average worker productivity and average assets ratios
b. Ratio of wages and average earnings
d. Average employment of entrepreneurial firms
Figure 5. Experiments with job finding rate (λ) – vertical dashed line indicates baseline value (0.56)
a. Allocation of individuals
c. Average worker productivity and average assets ratios
b. Ratio of wages and average earnings
d. Average employment of entrepreneurial firms
Figure 6. Experiments with corporate sector job offer rate (γ) – vertical dashed line indicates baseline value (0.75)
a. Allocation of individuals
c. Average worker productivity and average assets ratios
b. Ratio of wages and average earnings
d. Average employment of entrepreneurial firms
Figure 7. Experiments with entrepreneurial sector separation rate (ϕe) – vertical dashed line indicates baseline value (0.0)
a. Allocation of individuals
c. Average worker productivity and average assets ratios
b. Ratio of wages and average earnings
d. Average employment of entrepreneurial firms
Figure 8. Experiments with borrowing limit (b) – vertical dashed line indicates baseline value (1.5)
a. Allocation of individuals
c. Average worker productivity and average assets ratios
b. Ratio of wages and average earnings
d. Average employment of entrepreneurial firms
Figure 9. Experiments with mean entrepreneurial ability (exp(μ)) – vertical dashed line indicates baseline value (0.46)
Appendix
A
Algorithm for Solving The Model’s Equilibrium
A stationary equilibrium of the model is computed using an algorithm based on Huggett and
Ventura (1999). The algorithm finds an equilibrium by iterating over value functions and decision
rules over a discretized state space. Discretization of the continuous worker and entrepreneurial
ability processes in (1) and (2) is done using the Tauchen (1986) algorithm with a 21-point
support for the distribution implied by the process. The support is bounded below and above
the mean by 2.5 times the standard deviation. The asset grid is discretized to 201 points. The
spacing between points on the asset grid increases with asset levels. Asset gridpoints are placed
according to 1 = 0,  =   for  = 2  201, where  = 34  = ̄(201 ) and ̄ is an upper
bound. The algorithm is as follows.
1. Guess a value for the capital-labor ratio in the corporate sector, 
2. Calculate the values  = (1 − )  − and  =  −1 1− − ,
3. Set the initial value for the entrepreneurial sector wage equal to the corporate sector wage:
 =  
),  (e
), () () (  ∈ {   })
4. Calculate optimal decision rules  (), 0 (),  (e
5. Calculate  0 0 
R
()Ψ () and
R
Ψ () implied by the optimal decision rules,
R
R
6. If the values of | 0 0 − |   and | ()Ψ () − Ψ ()|   for some small
  0 and   0 then a stationary equilibrium has been found. Otherwise, update 
and   and repeat steps 4-6.
B
Estimation of the Parameters      and 
The estimation of the decreasing returns parameter,  for entrepreneurial firms, and the
parameters for the entrepreneurial productivity process, {    }, is based on the framework of
Abraham and White (2006).27 The framework is particularly suitable for the task at hand, as
it allows the estimation of the parameters {     } simultaneously. Consider a production
function for a manufacturing firm  in the form of
27
¡
¢
 −
 =    1−


Also see Castiglionesi and Ornaghi (2013) for a similar estimation methodology.
(16)
which includes materials and energy,   as an input, and a productivity process ln  = (1 −
 ) +   +  ln −1 +   where  is a firm-specific productivity parameter,   is a year effect
that captures general changes in productivity that apply to all firms, and  ∼ (0  ). The
parameters  and   vary across industries, but not firms. The inclusion of the materials
and energy in the production function controls for the use of intermediate inputs (materials
and energy) in estimating the underlying total factor productivity process. The estimation also
allows for a markup,  common to all firms in an industry, which can be thought of as the
average markup across firms that is assumed to be constant over time. Abraham and White
(2006) estimate the parameters, ,  and   in a GMM framework using the log-linear form of
the production function and the Solow residual obtained from the gross output and cost shares of
the inputs. See Abraham and White (2006) or Castiglionesi and Ornaghi (2013) for a derivation
of the exact model estimated.
The data used for the estimation is the U.S. Census Bureau’s Annual Survey of Manufactures
(ASM), which provides an unbalanced panel of manufacturing establishments for the period 19722009. The data include, for each establishment, annual measures of output (value of shipments)
and inputs (employment, materials/energy use, capital). This information is aggregated to the
firm level. The age of the firm is also available, which is the age of the oldest establishment
of the firm. The establishments included in the ASM sampling frame typically have size 20
employees or more, so the parameter estimates are not representative of very small young firms.
The model yields estimates of ,   and   for young versus old firms at the 4-digit SIC industry
level. The estimated values for young firms are then averaged across industries to be used in the
calibration of the baseline model. The analysis is limited to the manufacturing sector because
of the unavailability of similar data for other sectors of the economy (e.g. retail and services) to
calculate the revenue-based productivity of an establishment.
A remark is in order for how the estimated parameters of the three-input production function
in (16) are used to calibrate the model’s two-factor production function in (3). In the assumed
form of the production function in (16), the decreasing returns parameter,  is the same for
each of the three inputs. Because the decreasing returns parameter is common to all inputs, in
the model’s calibration the estimated decreasing returns parameter  = 088 is applied to both
inputs in (3). Similarly, the total factor productivity process is not specific to any input (i.e.
Hicks neutral) in (16). Therefore, the estimated productivity process based on the three-input
production function in (16) is assumed to apply to the two-factor production in (3).
Figure A6c Figure A5c Figure A7c Figure A8c Figure A9c